In the longstanding debate between stocks and real estate, a major point of contention has been liquidity.
Generally speaking, stocks are liquid, real estate is not.
Those on the side of stocks will argue that liquidity enables an investor to be nimble, allowing for flexibility to adjust to changes and risks as well as allowing for capital preservation.
Stock proponents contend liquidity hedges risk.
Those on the side of real estate will argue that to build true wealth, investors must be willing to take the long view. With illiquid investments, investors are better off in the long run because illiquidity prevents investors from making rash decisions that will preclude them from reaping the benefits of their investment before it’s time.
We make the argument that liquidity is a double-edged sword.
True, it allows for capital preservation and reduces risk, but it also encourages rash decision making when riding out a storm is often a better plan of action than cashing out.
The liquidity problem with stocks manifests itself in the form of volatility.
The stock market can and has been susceptible to mob behavior to the detriment of the market as a whole. And in the internet age where information travels at the speed of light, this mob mentality can exacerbate volatility at levels unseen in history.
In his seminal book, Extraordinary Popular Delusions and the Madness of Crowds, written in 1841, Englishman Charles Mackay discussed the pratfalls of mob mentality in both social and economic contexts. In his own words, the basic premise of his book is, “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”
In other words, people, when thinking in herds, do so only to their general detriment. On the flip side, they never act as a herd to their benefit. That’s why it only takes a day for a financial disaster to strike but years to recover.
This mob mentality is the problem with liquidity.
It allows investors to move markets, often in unison, to the detriment of all. Every major stock market collapse in history has demonstrated this hallmark of mass selloffs where persevering would have been the better alternative.
In the liquidity debate, those on the side of real estate will argue, justifiably so, that real estate’s illiquidity is what allows it provide higher returns to its investors than stocks in the long run.
In a 2011 research study, Roger Ibbotson, Chairman and Chief Investment Officer of Zebra Capital Management, linked liquidity, risk, and returns. Specifically, he found that extra returns come from less liquidity and higher risk. This explains why higher-return assets such as private equity and real estate are typically less liquid. Britton, Diana (2011) “Liquidity Is Expensive and Overrated.” wealthmanagement.com
Savvy investors who take the long view with most of their investments have long known that illiquid assets such as real estate provide higher returns.
Why do successful investors prefer illiquid investments such as real estate and indirectly, real estate private equity and real estate syndications? The short answer is that long-term, illiquid investments provide passive income opportunities essential for building wealth. Passive income, when reinvested, builds upon itself, generating wealth that liquid assets can not.
The key to growing wealth, as practiced by some of the savviest investors in history, is the cash flow element. Only from illiquid investments, such as real estate and even running a business that provides consistent cash flow, can wealth be grown by reinvesting that cash flow to effectuate a compounding effect.
One of the key benefits of illiquid investments is that it protects from mob rule.
In a private real estate fund where investors are expected to commit their funds for 5-10 years, illiquidity prevents collective madness from liquidating an asset before it has a chance to produce returns.
Illiquidity, in effect, saves investors from themselves and protects savvy investors who are committed to the long-term from being adversely affected by the irrational behavior of novices.
Because returns on real estate are generally predictable and reliable, the ability to weather the ups and downs of the broader markets is essential to cultivating the fruits of one’s real estate investment endeavors. This is made possible, in a large degree, to illiquidity.
For higher returns that allow for true wealth creation through passive income, investors should seek out illiquid investments, investments not subject to Wall Street volatility.
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